Afford Anything - How to Make Better Decisions -- with Dr. Brian Portnoy

Episode Date: September 24, 2018

#152: Dr. Brian Portnoy is an expert in making decisions. He holds a Ph.D. from the University of Chicago, he's a Chartered Financial Analyst, and he's the Director of Investment Education at Virtus Investment Partners. Dr. Portnoy joins me on the podcast to discuss how to make smarter decisions -- not only about investments, but also generally in life. How do we sharpen our decision-making skills? How do we improve our critical thinking processes? Here are some of the takeaways from our conversation. 1. Beware of resulting. Great results can come from poorly-planned decisions. And wise decisions can lead to good results on occasion. Don't judge a decision based on its results; judge a decision based on the soundness of the thinking process through which you made that choice. 2. Manage your expectations. Your happiness with an outcome will depend on the gap between your expectations and reality. If you can't control reality (at least, not completely), then manage your expectations. It's the happiness variable that's most under your authority. 3. Don't make hasty evaluations. When you go to a restaurant, you order a (vegan?) cheeseburger, and based on the taste of that burger, you can immediately evaluate your decision. You can't do that with investments. When you make an investment decision, there's a huge time-gap between when you make the choice and when you see the results of that choice. This time-gap may last for decades. And this means that your decisions are tough to evaluate. Don't judge an investment decision on one-year or two-year results, as tempting as that may be. Judge your decisions based on the soundness of the thinking, not the short-term ramifications. 4. Automate. It's the best way to save you from yourself. 5. Define risk. Some people think that "risk" is synonymous with volatility. Others think that "risk" refers to the loss of capital. Know what "risk" means to you. Personally, I define it as probability x magnitude. Today's guest, Brian, points out that magnitude can happen in a multitude of dimensions and verticals. 6. Diversification, risk management, and behavior. When in doubt, pay attention to these three factors. In order to better manage your investing choices, manage these qualities. You cannot control broad market outcomes, but you can control your exposure, risk, and choices. 7. You're the average of the 5 people you spend the most time with. Surround yourself with frugal, ambitious, reasonable, wise, intelligent, kind, adventurous people -- and you will become stronger in those qualities. You are in charge of the community with whom you surround yourself. Even if you can't change your physical neighborhood, you can form an online or digital community of people who support your goals and reflect your philosophy. 8. Keep a decision-making journal. What gets measured, gets improved. If you want to improve your decision-making skills, keep a journal of the way in which you make decisions, e.g. your thinking process. Then in the future, when you have the benefit of hindsight, you can look back on your decision-making process. Remember, don't judge your choices based on outcome; judge your choices based on the soundness of the decision-making process itself. Dr. Portnoy dives into detail about how to make better decisions in today's episode. Enjoy!   For more, visit the website at https://affordanything.com/episode152 Learn more about your ad choices. Visit podcastchoices.com/adchoices

You can afford anything but not everything. Every decision that you make is a trade-off against something else. And that's true, not just for your money, but also your time, your focus, your energy, your attention, anything in your life that's a scarce or limited resource. And so the questions become twofold. Number one, what matters most to you? And number two, how do you make decisions accordingly? How do you direct your day-to-day actions in a way that reflects what matters most? Answering these two questions is a lifetime practice, and that's what this podcast is here to explore.

My name is Paula Pant. I'm the host of the Afford Anything podcast and the founder of Afford Anything.com. And today, we're going to deep dive into the world of decision-making. We're going to talk about how to manage risk, how to minimize regret, and how to better understand the science of making good choices. We're going to discuss the gap between expectations and outcomes. We're going to discuss the tendency to conflate judging the process with judging the results. We're going to discuss the tension between being consistent versus being flexible. We're going to deep dive into what is risk exactly? What are the dimensions along which risk can be measured?

We're going to talk about loss aversion and missed opportunities. And the difference between skill and luck. My guest on the show today is Dr. Brian Portnoy. He has spent many years in the hedge fund and mutual fund industry and now he is the Director of Investment Education for Vertus Investment Partners. He used to work at Morningstar, which if you remember our previous podcast episode with Dr. Stephen Wendell, Stephen is also with Morningstar. Brian has a PhD from the University of Chicago, and he's a chartered financial analyst.

He's written two books, The Investors Paradox, and the Geometry of Wealth. In today's episode, Brian and I are going to discuss how to make better financial decisions. Let's kick it off. Here is Dr. Brian Portnoy. How are you? I'm excellent. How are you? Fantastic. Nice. So I wanted to talk to you about how a person makes decisions, the art and science of better decision making. That's a big part of where your professional experience has been. It's the metacognition of thinking about how to think. I'd like to dive into that.

One of the things that you mentioned in your book, The Investors Paradox, is that when you have limited information, it's hard to make decisions. but more information is not necessarily better. There's that tipping point at which an overabundance of information can be self-defeating. Why is that? Can you talk about how much information should a person gather prior to making decisions about anything? Right. It's an important question, and I wish there was sort of an algorithmic or a numerical answer to that, but you sort of don't know until after the fact that, you know,

we're really from a brainwiring point of view, seeking out a Goldilocks scenario where you don't want it to be too hot, you don't want it to be too cold. You don't want no information because that would be a difficult starting point in making a decision. But then having a ton of data can also be really overwhelming. I think whether it be with investment decisions or in any other profession, whether it be law or medicine or in technology, you name it, there is that sweet spot where you've collected enough information so that you know what the parameters of the risks are that you're taking, but then you're not then collecting tons and tons of more information, which does tend to be redundant. When you collect more

information, there is an increasing chance that you're basically just repeating observations that you're already familiar with. And so you have to be very, very, very sensitive to that. I think that this is what sort of distinguishes experts from novices in different fields, that sort of nuanced sense, more art than science, that you have enough to make a good decision, but not so much that your brain begins to shut down because it will. The brain does not like too much information. Right. Analysis paralysis. Yeah, that's a real thing. So given the fact that we don't know what we don't know, how do you know? that you have gathered enough information that you haven't overlooked any massive red flags?

It sort of has to involve the outcome itself. Part of what I talk about in the Investors' Paradox, but there's lots of wonderful books on decision-making. And so I've stood on the shoulders of giants in this regard is that, you know, we have to look at the decisions we make and the process that goes behind those decisions and then look at the outcomes that are associated with those decisions. most of the time we evaluate the quality of our decisions by the outcomes that they generate, but the challenge there, and there's a really fantastic writer named Annie Duke, who just published a book called Thinking and Betts. She makes this point beautifully, which is that we engage in

something called resulting. And I discuss, you know, even though my book came out a little while ago, I discussed this as well, which is the idea that, well, you know, that was a great outcome. The stock that you picked went up or the car that you chose ended up being a good car. Just because the outcomes are really good thing doesn't mean that you went around about the decision in the right way. And I think it's really important from a more sophisticated decision-making point of view to really put more time into the process of decision-making than just focusing on the result. And that concept of resulting, I think, is a fascinating one because it is absolutely correct that you could have a very good decision-making process that in one instance

leads to a negative result. And conversely, you could have a very poor decision-making process that happened to lead to an excellent result. That's right. In our world of investing in personal finance, you can choose a stock or a mutual fund or an ETF that you make the purchase decision and a year from now you say, was that a good or a bad decision? And you look to see, and I'm just obviously making up numbers, and it's up 10%. Well, the fact that you've made 10% on your money, that's a nice outcome. But whether or not it was a good decision, there's not a lot of information in that 10% figure. A lot of it has to do with, well, what were your expectations ahead of time?

And what was some of the causality behind that push toward a 10% result in the investment world? We make the distinction between alpha versus beta. And I'm sure you, I know you, but many of your listeners, you know, appreciate that beta is basically luck. It's what the market has given you. And then alpha is either positive or negative. It's the skill or lack of skill that you bring to bear. It's actually harder to assess alpha than many might suspect because you really have to understand the ground rules by which someone made a decision. And what are some of the best practices for those ground rules?

It's really content and context specific in terms of how you go about picking, and let's keep it in the realm of investments, of picking a stock or of picking a fund. I mean, there might be, you know, in the case of an actively managed fund, questions as to the tenure and experience of the manager, the process by which they go about, choosing securities within the portfolio, the way that they manage risk. And so you can look at the outcome, say, hey, this one up 10%, but that actually might be a bad outcome relative to expectations. The expectations are very much going to be context-specific and probably the overarching thesis

for the investor's paradox is that expectations matter. So generally in the science of happiness, there's a broad notion that when an outcome matches your expectations, then you're happy, at least for a while. And when the expectations are not met, then you're sad. But what it actually means to formulate an expectation for how an investment is going to go, how a relationship is going to unfold over time, how you're going to enjoy the house that you live in. I mean, the expectations apply to every experience from the trivial to the profound. Forming those expectations is not easy. It actually requires a fair amount of thought. And, you know, unfortunately, to make matters worse, when we're in a social

situation, we then have to coordinate those expectations with others. So whether we're choosing, so let's say we're going to purchase a mutual fund, it doesn't matter if it's an index fund or an actively managed fund. We have to have some sort of expectations going into that purchase decision so that at some point down the road, we can judge whether the outcome was luck or skill or a combination of both. But didn't you say that it's better not to make decisions based on outcome, since that would be resulting? Well, that's true, but I'm making the point that you want to be focused on the process, and you do need to measure sort of your decision-making process against something. It can't just be, I mean, you can have a brilliant process or what you think to be is a brilliant

process, but if it just ends up delivering bad result after bad result, you probably, should learn along the way that you've got a pretty crappy process. So yeah, I mean, outcomes matter, but the point of resulting is that you simply can't look at the outcome and say, oh, I like that that happened. And therefore, whatever I did behind the scenes, flip a coin, you know, count the clouds in the sky, or engage in a, you know, sophisticated, a kind of metric model, or whatever the case is, you can't necessarily just say, oh, because I liked the way it worked out, whatever it is I happen to have done by hook or by crook was the right thing to do. Now, you've talked about the gap between expectations and outcomes, the gap between predictions and results.

Does setting and expectation affect the outcome? Yeah, it's funny. Maybe you're alluding to a bit of a Heisenberg principle that just by conducting an experiment, you change the experiments itself. it's a philosophical question because we live in the world. This is all empirical. You know, at the end of day, it's not theoretical. You're choosing an investment or you're choosing a meal or you're choosing a partner and it works out or it doesn't. The emotional experience that you have along the way of that decision is going to be driven in part by the expectations you said.

Because if you have very high expectations, if along the way, it doesn't seem to be getting where you want to go. We're going to probably not be too happy, and vice versa. If the expectations are very low, then really everything is gravy. But it's important to, you know, again, to that Goldilocks scenario, set things in a way where you're not too hot and not too cold. So you want something that's not too hot, not too cold. and something that I don't think outside of the decision science is that many folks probably give a lot of thought too is the fact that there's a time gap between the decision you make and the outcome you observe.

And one of the hardest things about investing is that we'll make a decision. Okay, so we'll invest in a fund in our 401k plan or we'll purchase a stock in our brokerage account. We'll put money in a savings account. well, in many cases, the ultimate outcome of that decision is not known for decades. And it's really not part of our human wiring to have that sort of time frame. In fact, for the most part, we live in the here and now. Most of our brain is just sort of wired to be kind of in the moment, making sure that we're safe, making sure that we're avoiding danger.

So in lots of other areas of decision making, I'd even say in areas of consumption, imagine going to a restaurant, you order a cheeseburger, you bite into the cheeseburger, and boom, you know whether it's a good experience or a bad experience. You go into your 401k and you adjust your asset allocation and you move it from 60% stocks and 40% bonds to 50-50. Was that a good decision? Well, number one, you'd have to go through the intellectual exercise of measuring the counterfactual.

What would it have been the case if you hadn't made that decision? if you had just left it at 60-40. And then second, for any of those sort of retirement-oriented decisions, it's really measured in decades whether or not you did the right thing. So setting expectations can impact the outcome only in the emotional sense that if there's a huge timing gap or a feedback gap between decision and outcome, that's going to impact you along away. That's a great point. How do we emotionally manage the inherent problems that that time gap creates? And I'm thinking about 2008, 2009, when people who may have made what were wise, sound, long-term decisions within their retirement portfolios saw their world collapsing around them in

2008, 2009. And because of what was happening at that particular moment in time, decided to harvest all their losses in March of 2009. Let's go to all cash, which of course, now a decade into the future, it's easy to look back on that and say, well, obviously that was a poor decision. And even at the time in 2009, it was easy to look at the last hundred years of historic data and still say that's a bad decision. But how do we emotionally manage for the fact that there is going to be a significant time gap between decisions that we make and those outcomes? Well, so, yeah, So this is great. So you're really getting to the heart of not only just investment decision making, but financial planning. And it's something that I've given a lot of thought to in the investor's paradox on a follow-up book called the geometry of wealth.

I dove into this topic in some depth, more from a philosophical point of view with a little neuroscience mixed in, meaning that one of the truly distinct attributes of the human is the ability to transcend time mentally. So we are time travelers. So we're telling stories about ourselves all the time. We're creating our own narratives every day. And as part of that, our minds kind of zip back and forth between the present, the past, and the future. And so we've got imagination going forward. We've got memory going backwards. It ends up that many of our memories are completely inaccurate. Some stuff didn't happen, probably different conversation for a different day. So we're trying to connect the dots with a dynamic time landscape, which, and again, this is a This probably sounds a little pie in the sky, but it's a really positive thing because that ability to think forwards and backwards in time was one of the, if not the most important thing that separated us from other species. It allowed us to plan and to anticipate to run away from danger, to sprint toward opportunity. So us as time travelers, it's a really good thing. Now, that part of the brain developed more than 100,000 years ago. You know, that sits kind of at the deep core of who we are. Fast forward to today, you then have to think about the fact that the brain did not evolve to navigate modern capital markets.

It didn't really evolve to make decisions where you didn't know the outcome for years or decades. And so what do you do? There's a few options on the table. The default is that you just have to be disciplined. You listen to your podcast. You read my books or you get an MBA. and you sort of learn all the rules of the road in terms of investing. And you're just taught to invest for the long run, buy and hold, be patient, all that kind of good stuff.

That is our default. Most people do a terrible job at that. There's substantial evidence that shows that as a community of investors, we buy high and we sell low. We do the opposite of what we're supposed to do because of that short-termism. And your 2008-2009 example is by far the most professional. I mean, really folks put themselves in a really bad spot by selling at the bottom. But there are other options. In one direction, you can make the decision a social one.

And this is where I think financial advice and financial planning come into play. I'm a big fan of people having a money coach in life, a financial advisor, somebody who can help them understand the risks that are coming down the pike. You can't eliminate the risks, but you can certainly. manage them. People who work with financial planners tend to end up in a better spot. Not because the financial planner really knows anything better or different about the market. They're not a guru. You turn on financial television and you look at the actual track record of folks. It's quite lousy. So it's not, yeah, it's, I'm not going to name names, but people can guess who I'm talking about.

And when you work with a financial advisor, what they can end up being is really a behavior. behavioral coach who can help you make better decision during times of duress. The other option, so we have full discretion, which folks tend to screw up, you can have someone help you, or you can give up decision making, meaning that you can automate your decisions. And now we have lots of new technologies and software where you can say, you know what, every two weeks from my paycheck, I want to contribute 5% of my gross income into my retirement plan. You turn it on, you know, your first day at work and your job for five, ten, 20 years, however long you are.

And you probably don't think much about that small amount that you put away every two weeks. But we know through the power of compounding, no matter how good or bad the markets are, that tends to end up being a really great situation. And along the way, we've made only one decision. And we made it a long time ago, which was to participate. And after that, just like Ulysses in the Mast, who couldn't resist the Siren song, We basically said, we can't resist the siren song of volatile markets. We're going to sell in March of 2009, only to watch the market go up 400% over the next 10 years.

Because of that, we're going to sort of outsource that decision to an algorithm or to an automated plan. So automation is one of the ways that we can save ourselves from ourselves. Yeah, to this point you made earlier about we don't want too much information. By the same token, we don't want too much choice or too. much freedom. It's actually, it can be a politically sensitive point in the sense that, you know, liberty and freedom's a great thing. We all want to be able to do what we want to do. The issue is that, and there's lots of interesting psychology on this, including a book called The Paradox of Choice by Barry Schwartz. Yeah, excellent book. Yeah. You know, my book's called The Investors Paradox.

It's about how do you make these sorts of decisions when you have so much choice that it can be overwhelming. We've known for millennia that having a lot of choice is a really good thing. We've only known for decades that you can have too much choice such that it really paralyzes you. Sometimes the best thing we can do to help ourselves is to give up choice. It's not something that many might be immediately comfortable with, but I think the benefits of it. And maybe this is coming across as a little dramatic or philosophical. At the end of the day, especially as it relates to retirement savings, sign up for your retirement plan, sock money away every pay period, and you're going to be in a lot of time.

a lot better shape than nearly everybody else. You also mentioned getting a money coach or getting a financial advisor. How do you make sure that when you choose that person, that it's not the blind leading the blind? That's a tough one. I work in that industry. I sort of speak and coach on behavioral finance and its various topics to financial advisors. I think asking the right questions, but also understanding what situation you're in, whether you're in your 30s or your 60s, whether you're a man or a woman, whether you work in a very stable industry or

you know, in venture capital and things can be quite volatile. Take into account your situation and then do the work to find a financial planner, broadly defined, that has helped people just like you because everybody is sort of special in their own way. But we are all part of a cohort. And if you can find someone who's done a nice job and make some reference calls, find out who they've helped, find out about success stories, find out about failures, ask those questions. And if you can find someone who's helped someone just like you, then the chances that they're going to be successful with you are pretty high. We'll come back to this episode after this word from our sponsors. Did you know that the average out-of-network ATM fee is $4.69?

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Again, that's litote.com. L-E-T-O-T-E dot com. Enter your code, Paula. You mentioned in your book that there are four attributes that you look for, trust, risk, skill, and fit, which boils down to, can I trust you, what do you do, are you good at your job, and are you the right fit? And what's notable about that is that none of those are,

performance, even though performance is what's sold. That's right. And this gets to the issue of resulting and measuring things based on outcome. Performance comes and goes. Stocks go up, stocks go down, market goes up, market goes down, and we have close to no control over that. The only thing that we really have control over is sort of the philosophy that we bring to bear to a set of decisions and then the process that we've constructed that sort of represents or abides by that philosophy. So the investor's paradox is based on, you know, I had a career for about 14, 15 years in manager due diligence or manager research. So I worked at Morningstar. I worked at a firm called Mesero, which at the time was a large

fund of hedge funds. So I was involved in kind of a profession that would evaluate money managers to see if they're good at what they do. You're very astute to point out that I really never talk about performance because that is so fickle. The four things that I do talk about, I think that we can do really good work on to understand what we're getting. And if these four boxes are checked, so to speak, I think our chances of success are quite high.

So real quick, and we could dive into whatever you want, if you'd like. But trust, it's the number one issue. I have a whole chapter where I anchor on the story about Bernie Madoff, which most people know the high-level story there. But it's just a real tragedy because part of it is just from a brain-wiring point of view. We'd like consistency. We don't like things that are erratic. And here is somebody over the course of decades produced an unbelievably consistent track record. The problem is that it was completely made up.

Obviously, we know in retrospect it was a Ponzi scheme. And people fell for it. unfortunately. We really need to think about trust not only in an individual sense, but when we build an entire portfolio. This is one reason diversification is so important. You don't want to have all of your money with one person or one organization. You want to spread it around. And so again, to reputation, to asking hard questions, what are you good at? Where have you made mistakes? What have you learned? Those are things that we need to be comfortable to ask in order to assess trust with risk. There are several different metrics that you can use that will give you a good

sense as to what sort of experience you're going to have along the way as you're investing for many years. So, for example, if it's a very concentrated portfolio, it's more likely to be a bit volatile and bumpy and you have to be prepared for that. There is complexity, how much complexity is a manager or an investment engaged in. And that's just not true in the active sense. It's also true in the index or passive sense, you can have a passively managed index that invests in very complicated situations. So you want to know how to set expectations. What would be an example of that? When you're indexing niche markets, pick any industry, whether it be in technology or healthcare or in industry, you know, there are sub-sub-sub-industries that you can buy

exposure to, but you begin to get into taking on exposure to narrow and hard to predict corners of the market. And unless you have some insight into those corners of the market, could be some element of technology, could be crypto. I mean, crypto is a good example, incredibly complicated. And people are betting on it like it's a casino, not entirely healthy behavior, in my opinion. And when you get into very complex situations, things can go wrong in ways that you can't imagine versus broad, market-based, very diverse exposure where it's less likely that something is going to undermine what you do. So something like a frontier market or even a specific country within a frontier market or crypto.

Yeah, that's right. Frontier markets is a good example, let alone a single country frontier market. it can be up 80%, you could be down 80% to have that sort of, unless you're a professional speculator, and I don't really, you know, that's not who I really cater to, and I don't think that's your audience. Unless you're a professional speculator, having exposure to those sorts of things, it's impossible to set expectations for them, meaning that it's nearly impossible to gather whether it's worked out or not worked out. It's basically all lock, no skill. Most folks, as a practical matter should stay away from those sorts of things.

So we've talked about two different aspects of risk, concentration and complexity. In your book, you mentioned five risk dimensions, the other three being directionality, leverage, and liquidity or illiquidity. Yeah. Can you talk about those other three? Absolutely. Yeah, because I was just giving a couple examples of how I talk about risk, but yeah, you're right.

It's important to maybe mention all five. So covered concentration and complexity. Directionality, and maybe that's a clunky word, because, I had spent so much time in the hedge fund industry where there are many complex strategies, including long short equity and market neutral strategies, there are lots of strategies that have less than full market exposure. If you invest in a standard mutual fund, Vanguard 500 or Fidelity Magellan or anything like that, you're going to be 100% invested. There might be a tiny cash position, you know, for frictional trading. But for the most part, you're 100%

invested, you're 100% long, and there's no leverage on the one hand, and there's no shorting on the other. And therefore, as a result, you sort of have a standard, you know, sort of 100% long investment. That's, you know, I think normal for most of us. But when you break out into more complex strategies, then that constraint is relaxed. You can have leverage. So instead of being 100% long. You can be 200% long because you can use basically borrowed money to double your bet. Or you can go completely neutral to the market. You can bet $100 long and you can bet $100 short and therefore you've got $200 of exposure, but you have $0 of market exposure. I'm not going to maybe bore you with all the technical elements of that, but directionality is something that we need

to be aware of. Another of the five, and I just referenced it, is leverage. That works both ways in terms of having borrowed money in order to bet more, or you could have negative leverage. You could be sitting in cash, and a lot of people actually do that. I just was talking to a senior financial advisor the other day at a very prominent firm, and she was telling me about some clients who have been sitting largely in cash since 2009. They've just never felt comfortable getting back in, and unfortunately, that's not a unique story. And then the fifth of the five risk dimensions, as I like to talk about, is illiquidity.

The underlying securities within the portfolio be sold easily or not easily. And we saw in 2008, 2009, that there can be illiquidity even where we don't expect it to be. As it relates to the U.S. stock market and major European and Asian stock markets, not a huge issue on a day-to-day basis, but it can creep in to the conversation during times of duress the fixed income market. You know, so for bond investors, illiquidity is a much more serious issue because that's a dealer market as opposed to an electronic market for the most part. I mean, it's changing in some complicated ways. And so as we saw, again, in 2008 and 2009, fixed income markets, even in what are considered

to be very liquid securities, can shut down because there's just nobody on the other side of the table who wants to take the trade. You really have to think about those five sorts of risks that can undermine what otherwise would be seen as a very thoughtful portfolio. Right. Absolutely. It's funny, when I was reading about the five risks dimensions, I was thinking about it in the context of an individual investor who buys a single rental property, one, two, three, Main Street, located in Birmingham, Alabama. And I was thinking, wow, if we were to take a decision like that and put it up against your five risk dimensions, there's huge concentration. There's oftentimes, but not necessarily big leverage, 5x leverage. And it's relatively illiquid

depending on whether or not you find a buyer. So compared to these five risk dimensions, I mean, directionality, it's only, it's straightforward. Yeah, straightforward. Complexity is perhaps a matter of interpretation. So yeah, when I think about this risk model, as it applies to a rental property investor, I can see all of the risks there that are necessary to manage. Yeah, I built this as just a generic model to think about the types of investment risk that you're taking. In your rental example, you've shown that on three of the dimensions, you're pretty far out there. You're taking a fair amount of risk. And then the other two, not so much. In my experience, as an analyst and a portfolio manager and as a counselor and coach to

others, the word risk gets thrown around a lot, but rarely does the conversation get into the weeds at all with any specificity on, well, what do you mean by risk? I feel like five dimensions. You and I, us and a financial advisor, a portfolio manager, and an investor, any sort of conversational dynamic, these five dimensions, I think or I hope can elevate the conversation so that you kind of know what you're getting into all back to that broad point that what we're doing is managing expectations. And, you know, that's a very good point because I've heard people use the term risk in two different ways. I've heard some people use risk as synonymous with volatility, and I've heard others use risk as an expression of the chance of the loss of initial principle

contribution. So even the definition of risk should probably be stated forth bluntly based on who you're talking to to make sure that you're even having a conversation from the starting point of the same definition. Yeah, it's really one of the more underspecified and misused terms in all of finance. You know, Warren Buffett and other luminaries, they have said many times that volatility is not risk. It's only permanent loss of capital. I happen to disagree. I mean, never comfortable to say Warren Buffett is dead wrong. But in this case, I think that he is in the sense that what most of us are doing who don't have tens of billions in the bank, you know, we're just trying to meet normal financial goals, you know, a college for our kids, a sound

retirement, a nice home, maybe some other stuff. But, you know, many of us share similar objectives. And the real risk in our lives is not being able to have those things, not being able to afford your kids college. And then you have to go into debt, continuing to work after your 65 or 70, because you haven't saved enough and so on and so forth. The reason that volatility is risk, in my view, is that in highly volatile situations, people tend to bolt. We've already discussed the fact that when things get shaky, that sense of danger kicks in, and we want to go.

And so people did sell in 2008 and 2009. They didn't come back in. And so if the real risk that we're managing is the ability to meet or not meet our goals, and volatility knocks us out of our portfolio, and makes us very squirmish about getting back in, then volatility absolutely is a form of risk. We'll return to the show in just a moment. Hey, do you wear contact lenses?

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of behavioral finance and managing ourselves and managing expectations. One of the things that you talked about in your book is this tension between consistency and adaptation. There is this notion of create rules and then break them. And in order to do that, you kind of have to create rules around when you will break the rules. In 2008, 2009, there were so many people who said, I'm a buy and hold investor, but this time it's different and this time I'm going to break the rules, which of course in hindsight we know. was a bad decision. How, I'm not even quite sure how to phrase this question. How do people square the circle? Yeah. You're asking hard questions. This is good. This is good. The brain is wired in a way to

not make things easy. We absolutely do want consistency. We often see patterns in our lives that aren't there on a daily basis because the brain subconsciously kind of connects dots just so the world will make sense to us and doesn't seem chaotic. But by the very same token, one of the reasons that we've survived as a species that we've been able to adapt. We live by the rules, but then the rules will change over time. And so how do you do that? I think this is, and I pose this as a question or even a challenge to portfolio managers, but it's really true for all of us in our professional lives, and to some extent, I guess, even in our personal lives, which is how do you stick with kind of your core principles while at the same time developing or evolving in a way, because the world outside

is changing. And that phrase this time it's different. I know that those are the words you're not supposed to say, but, you know, things are different. I'm, you know, student of and a big believer in historical processes and the line that history doesn't repeat, but it rhymes. Things come and go. So you want to be a buy and hold investor, but do you bolt into? 2008, 2009, I think the entire structure of global capitalism was within three or four days of disintegrating in the fall of 2008 and maybe different conversation. But stuff going on behind the scenes with central banks and governments and major corporations, like those were even scarier times than people might realize. If things had gone as they very well could have gone, then that buy and hold decision would have been. been, you know, that wouldn't have been the right thing to do. So when you get these big once in a

decade episodic decisions, it's really hard because you don't really get any do-overs. You only get one or two or three of these big decisions in your entire life. And so it's not like, you know, there's thousands and thousands. You know, we don't live Monte Carlo simulations. Our lives are the opposite of that. I mean, I'll give you a more current and less dramatic example, which is the fact that value investing has not seemed to work, quote unquote, worked for eight or nine years now, really through most of the post-crisis era, starting in 2009, growth stocks have outpaced value stocks. And so you have a lot of underperformance from active managers because they tend to tilt toward value. You have lots of people bolting from value strategies because we like to chase performance.

And performance has been on the other side of the style box. at what point do you say this isn't working anymore value investing doesn't work anymore and you're going to go do something else or do you stick to your guns and you say you know buying cheap has worked for a century or two or three and even though it hasn't worked for the last 10 years which are nine years which in the grand scheme of things isn't all that long although it's a good chunk of our lives it's not a you know it's not a good chunk of history we're going to stick with it or not again i wish there was something algorithmic I could share with you and your listeners. To me, it's just important to be broadly principled about having clearly articulated objectives, owning diversified

portfolios that are tied to that, that kind of play the long run game in terms of what works versus what doesn't. And you kind of hope that it works out, even though sometimes it will not. So cross your fingers and hope it works out. Yeah, that's kind of life in a nutshell. But, you know, on the, you know, I don't want to say easy, but on the easy to define scenario of planning for our financial futures, I really do think in terms of three pillars, diversification, risk management, and behavior. Diversification is something that sounds great, but lots of people, most people hate diversification because it means holding a portfolio with stuff in it that's, quote, unquote, not working, you know, such as value stocks over the last five, ten years. but still, the other option to diversification is to make big bets and hope that you're right. And few people can get away with that. Second principle, risk management.

Think about minimizing regret before you maximize gain. We like to minimize regret. It feels good. And when all is said and done, we tend to look back and put a lot of emotional valence on those regrets. So we really should work to avoid them. And so putting risk first is critically important. And then recognizing that most of this entire game is about our own decisions. This isn't about beating the market.

It's about controlling ourselves. And that's something that needs to be taken seriously. And you made or actually implied a really important point just a few minutes ago, which is that we have been talking a fair bit about 08 and 09. That's really the last time that the market went down a lot. And so I think a lot of people have now forgotten, unfortunately, that markets do go down. And the two-step game is that, well, the market, happens, but then you have to decide how to react. And if you had just stayed in in 08 and 09,

you ended up just fine. You just needed to weather some emotional discomfort. So we're appreciating that your own behavior is more important than market prognostication may sound straightforward. Most people don't operate in that way. Let's talk a little bit more about that. How do you become a better manager of your own behavior? Well, again, it gets back to the kind of three-fold, you can just learn and be smarter and savvier. You know, you retain discretion over everything that you do. And we're wired a little bit differently. I don't find day-to-day investing in the slightest bit interesting. I don't know why. I also don't like the color yellow. I don't know if that's the case. It's just who I am. So I really don't have personally any

challenge with the buy-and-hold philosophy, but the whole principle of don't just do something, stand there. A lot of people don't like that. They need to feel in control and control suggests activity and activity leads to churn and churn usually doesn't produce an optimal outcome. So there's education and there's discipline that we can bring upon ourselves because ultimately firmly believe that we're each in control of our own destiny. But beyond that, again, And not only working with a financial advisor, but living and socializing in a community broadly defined, I don't mean just sort of your block and who your neighbors are, but in our virtual communities in terms of Twitter and Facebook and what we choose to look at and see how

others are modeling behavior, you know, if you hang with a fast crowd that's focused on fancy purchases, that very well could be the way that you operate as well. You know, there's a bunch of studies on this on how we make comparative judgments. You know, there's a study that gave someone a choice, which was you can make $50,000 a year and your neighbor makes $30,000 a year. Or you can make $100,000 a year, but your neighbor makes $200,000 a year. A majority of the people chose to live on $50,000. So what others are doing, keeping up with the Joneses is an incredibly powerful thing.

You remember the older book, The Millionaire Next Door. A lot of what that was about was folks that were driving older cars but had millions and millions in the bank. And they kind of hung out with people like them where they didn't feel the need to keep up with the fancier cars and the bigger homes. And ultimately it's everyone's personal decision how they want to live their life and what they want to buy or not buy and that sort of thing. But if we're talking about controlling behavior, surrounding yourself with other. that you want to model is a very powerful force. So, you know, modeling or social proof is a very powerful force. But again, these are choices that you can make, especially now in our digital world,

where you can kind of hang out with anybody you want on any of the big platforms. That's right. Our brains will adapt to whatever we feed it or our minds will adapt to whatever we feed it. We are constantly looking for approval. You know, our brains have a certain, you know, some of the more fascinating neuroscience, taking place now is really about the connections between our brains and how the neural activity in your own head is tied to somebody on the phone with you or sitting across the table from you or that you see on the internet or Twitter or wherever. You know, it's a very social thing. So

you can choose to be around the people that you want to emulate. And if you choose to be around people who demonstrate behavior that you'd rather not engage in, to me, it's kind of on you that you've chosen to be in that cohort. It doesn't mean that it's hard to break away. It doesn't mean that there aren't costs. But we all need to engage in those decisions. One other thing. You mentioned in your book the difference between errors of omission versus errors of commission.

Can you talk about that? Because I thought that was a fascinating concept. Yeah, yeah. Well, that's not me. That's just basic decision theory and some statistics. But the first fork in the road I'd point out is that there's a difference between a mistake and a bad out A bad outcome is something that was in the realm of possibility that you hoped wouldn't happen, but it did.

And so, you know, you choose an investment and the investment loses some money and you know investing in the stock market is risky and losing money is a possibility. You didn't necessarily make a mistake. You encountered a bad outcome. If you had a particular mindset that particular stock or bond or mutual fund or ETF, you convince yourself it was going to make 8% of you. year for the next five years and lo and behold it loses a bunch of money well there you've gone through a thought process that isn't particularly realistic and you know that would fall into the mistakes category so

you you had wildly wrong expectations so first order of business is that bad outcomes happen all the time even though we don't want them to but such as life mistakes happen when we engage in a really lousy decision-making process or expectations formation process in the world of mistakes You've got really two types of errors, errors of omission and errors of commission. Errors of commission are what we think about when we normally use the word mistake. You know, I made a bad decision. I was supposed to go left at the stop sign, but I went right. I was confused or I was lost.

And as a result, I made an error of commission. I went the wrong direction. It was something that I did. Errors of omission are things that you don't do. So you're inactive and you don't decide to do something and then the world happens and you're kind of left flat-footed. So if you think about, you know, those who choose to opt out of their where they don't even think about it, I should say they're participating in their firm's retirement programs, especially where there's matching funds involved, meaning that the company basically gives you free money to add even more to your retirement account. And then you don't really have anything saved for retirement and you haven't really thought about it. that's an error of omission. You didn't do something, and as a result, you had a really bad outcome.

So we need to think about both decisions and non-decisions as sources of possible pleasure and also sources of possible pain. I'm chuckling because the further you go down the rabbit hole in the decision sciences, you begin to realize that there are so many ways that you can screw things up. But the silver lining, and it's a thick silver lining, is that a little bit of thought about the consequences of both decisions and non-decisions, just a little bit of thought, I think, can go a long way in avoiding the worst possible outcomes and probably putting yourself in a position to have some good outcomes. And we're hardwired to feel the sting of a bad decision more so than we are to feel the sting of a missed opportunity. that loss aversion is so much more painful than missed opportunity? Yeah, missed opportunity, you know, you didn't short subprime bonds in 2007. So unlike John Paulson, you didn't make $3 billion that year. That's a bummer, and you might regret that, but you didn't really do anything wrong.

It really wasn't part of your decision set as a result. You don't have $3 billion, but you also didn't lose money. Yeah, loss aversion is the principle that losses feel worse than gains feel good. It's a very powerful motivator. It's one of the reasons, and I've written about this and give lectures on this, it's one of the reasons why even though diversification sounds like a very basic and common sense principle in how to invest, many people thoroughly dislike their diversified portfolio because by definition there are certain investments in the diversified portfolio. that don't do well as others, and so we think of those as not working, and we add sort of extra

emotional weight to those things that are losing money that are lagging behind. Scientists set the ratio at about two to one, meaning that a $100 loss feels twice as bad as $100 gain feels good. And when we begin to think about that as it relates to the suite of decisions we're going to make. That's why I stressed earlier that risk management is so important. Because managing those risks and minimizing regret has more emotional, positive emotional weight to it than does picking the winner. Picking the winner feels good. Owning the loser feels even worse. Those are all of the questions that I had for you. Are there any final takeaways that you would like this audience to have? I mean, when somebody's finished listening to this interview, what should

they walk away with? What key ideas? Yeah, I think the key idea is in any realm where you want to succeed, you need to think ahead of time about the decisions that you're going to make. When it comes to the world of investing, we do want to look out to our objectives. And again, we have many shared ones in terms of a nice home and college for our kids and a comfortable retirement. And you want to back into a plan that gets you there. A mistake that many people make is they conflate plans with goals. It's one thing to make. It's very different to have a plan. And then another distinction on make is that there's difference between having a plan and engaging in planning. So engaging in planning means that you understand that you're not going to make just one decision at age 25 and 40 years later. You're going to come back at

age 65 and say, hey, I wonder how it all went? No, that's not the way it goes. We have to appreciate that we're going to be getting feedback along the way as to how things are going. And some of that's going to be noise and some of that's going to be important signal. You can't really know ahead of time until you've developed a lot of experience, what's noise and what signal. But you can be really thoughtful. And I would encourage people to write it down. I would encourage people to keep a decision journal as it relates to their portfolio and their financial plans. Because having something on paper that you can come back to, something that you've date stamped that you've written, hey, in August of 2018, I decided to do this.

And this is what I hope it's going to produce. And this is the ways, at least at present, I'm thinking it could go wrong. And here's how it might go right. And then you review that periodically. Very few of us do that. but it's a very healthy thing to do. So big takeaway, we're in control of our own decisions, and we need to be thoughtful about the process by which we make them and evaluate them over time. I like that tip about keeping a decision journal.

Yep. It's kind of a pain, but it's super useful. Absolutely. Well, thank you so much, Brian. Where can people find you if they would like to know more about you or your work? Yeah, absolutely. So I'm the director of investment education for Vertus, investment partners. And so at vertis.com, there's a whole section on there with thought leadership where I've written a number of white papers about exactly the types of decisions we've been talking about today. My Twitter handle is at Brian Portnoy, and I'm quite active on Twitter with a lot of other folks who are kind of obsessed with behavioral finance and decision making. And then finally, I have a personal website called Shaping Wealth. And that gives some details on the two books that I've written and some other fun stuff. And we have a link to all of those in the show notes.

Wonderful. Well, thank you so much, Brian. Oh, thank you. It's great. Brian, thank you so much for this conversation. What are some of the key takeaways? Here are eight. Number one, beware of resulting.

Sometimes sound decisions lead to non-desirable outcomes and vice versa. Sometimes a highly desirable outcome will come from a poor decision. So do not conflate the outcome with the thinking process that it's, took to get there. Just because the outcomes are really good thing doesn't mean that you went around about the decision in the right way. And I think it's really important from a more sophisticated decision-making point of view to really put more time into the process of decision-making than just focusing on the result. Remember that method matters more than content. A person may get lucky or unlucky. Do not judge based on result. Judge based on method. So that's key takeaway

takeaway number one, takeaway number two, manage your expectations, because ultimately, whether an outcome is good or bad, depends on the gap between what actually happened versus your expectations of what would happen. In the science of happiness, there's a broad notion that when an outcome matches your expectations, then you're happy, at least for a while, and when the expectations are not met, then you're sad. But what it actually means to formulate an expectation for how an investment is going to go, how a relationship is going to unfold over time, how you're going to enjoy the house that you live in. I mean, the expectations apply to every experience from the trivial to the profound. And so what you're looking for is to set a

Goldilocks level of expectations. Don't set the bar too low or too high. The emotional experience that you have along the way of that decision is going to be driven in part by the the expectations you said, because if you have very high expectations, if along the way, it doesn't seem to be getting where you want to go, we're going to probably not be too happy and vice versa. And so that is key takeaway number two. Manage your expectations with regard to your investments, your businesses, your relationships, with regard to everything in your life.

Because ultimately the purpose of all of this is to be happy. And the science of happiness states that the smaller they, the smaller they're not. gap between expectations and reality, the happier you are likely to be. And conversely, the larger the gap between expectations and reality, the more unhappy you are likely to be. So by managing expectations, we can manage our own happiness levels or satisfaction levels. So that's key takeaway number two. Takeaway number three, when you're making a decision about an investment or a business or a side hustle, remember that there's going to be a time gap between when you make that choice and when you see the consequence of that choice.

And sometimes this time gap might be years or decades. And that means that evaluating decisions around these topics are much harder than evaluating decisions based on what you order at a restaurant. Imagine going to a restaurant. You order a cheeseburger. You bite into the cheeseburger. And boom, you know whether it's a good experience or a bad experience. you go into your 401k and you adjust your asset allocation and you move it from 60% stocks and 40% bonds to 50-50.

Was that a good decision? Well, number one, you'd have to go through the intellectual exercise of measuring the counterfactual. What would it have been the case if you hadn't made that decision if you had just left it at 60-40? And then second, for any of those sort of retirement-oriented decisions, it's really measured in decades whether or not you did the right thing. As you're evaluating decisions, make sure that you're not giving undue influence to the result or performance of your decision in the last six months or one year or even two or three years. When it comes to choices that you make around your investments or your businesses or your career, there can be a multi-decade payoff. And that makes it harder to evaluate decisions in multiple

regards. It makes it harder to look at the performance of the past couple of years and know whether or not you've made the right choice. It makes it harder to have confidence in your decisions as conditions change. And it makes it all the more important to rely on principles rather than performance when you are evaluating the choices that you've made, the decisions that you've made around your investments in business. And if there's a broader takeaway that comes from this entire conversation, it's that it's make those choices based on principles rather than performance. That is key takeaway number three. Takeaway number four, one of the best ways to rescue ourselves from our own humanity is through automation.

It's a really positive thing because that ability to think forwards and backwards in time was one of the, if not the, most important thing that separated us from other species. It allowed us to plan and to anticipate, to run away from danger, to sprint toward opportunity. So us as time travelers, it's a really good thing. Now, that part of the brain developed more than 100,000 years ago. You know, that sits kind of at the deep core of who we are. Fast forward to today, you then have to think about the fact that the brain did not evolve to navigate modern capital markets. It didn't really evolve to make decisions where you didn't know the outcome for years or decades.

The modern mind was not designed to deal with the modern market. Our brains did not evolve in an era of Twitter and Wall Street. And so in order to rescue yourself from your own inherent cognitive biases, use automation. That way, as Brian says, you only have to make a good decision once and the rest takes care of itself. So that is key takeaway number four. Takeaway number five, understand your definition of the word risk because people define this term differently. Some people think that risk is synonymous with volatility. Other people think that risk is the loss of initial capital.

And as Brian suggests, risk to him is a nuanced word that operates along five dimensions, which are concentration, directionality, leverage, liquidity, and complexity. And each of those dimensions has its own level of magnitude. Personally, I've always defined risk as probability times magnitude. But as Brian points out, that probability times magnitude could happen. and in multiple dimensions. So be clear about the way that you yourself define risk. What does it mean to you? Warren Buffett and other luminaries, they have said many times that volatility is not risk.

It's only permanent loss of capital. I happen to disagree. I mean, never comfortable to say Warren Buffett is dead wrong. But in this case, I think that he is in the sense that what most of us are doing who don't have tens of billions in the bank. We're just trying to meet normal financial goals, you know, a college for our kids, a sound retirement, a nice home, maybe some other stuff. But, you know, many of us share similar objectives. And the real risk in our lives is not being able to have those things, not being able to afford your kids college and you have to go into debt, continuing to work after your 65 or 70 because you haven't saved enough. And so on and so forth.

So that is key takeaway number five. Know your definition of risk. Key takeaway number six, when in doubt, fall back on these three principles, diversification, risk management, and behavior. In order to better manage your investment choices, manage these three things. And then recognizing that most of this entire game is about our own decisions. This isn't about beating the market. It's about controlling ourselves.

and that's something that needs to be taken seriously. It's not about beating the market. It's about knowing ourselves. Self-knowledge is the key to success. So that is key takeaway number six. Key takeaway number seven, you are the average of the five people that you spend the most time with.

That's a Jim Rohn quote. And it's true. Surround yourself with not flashy, not fancy, frugal, reasonable, intelligent people. And by surrounding yourself with those people, you will start to reflect them. You remember the older book, The Millionaire Next Door. A lot of what that was about was folks that were driving older cars but had millions and millions in the bank.

And they kind of hung out with people like them where they didn't feel the need to keep up with the fancier cars and the bigger homes. And ultimately, it's everyone's personal decision how they want to live their life and what they want to buy or not buy and that sort of thing. But if we're talking about controlling behavior, surrounding yourself with others that you want to model is a very powerful force. So, you know, modeling or social proof is a very powerful force. You are in charge of the community that you surround yourself with. And thanks to the Internet, choosing your community is easier than ever. Even if you cannot change the physical neighborhood that you live in, you can choose to surround yourself with like-minded people. While you're online, you can form a digital community of people who will encourage you and support you and share in the goals that you have.

And so if you want to live a frugal life in which you pay attention to your money, you save well, you invest well, one of the best ways to do so is to surround yourself with other people who share those same goals. And so that is key takeaway number seven. Choose your community. Finally, key takeaway number eight. And this is an action item that you can do today. Keep a decision journal. Because having something on paper that you can come back to,

something that you've date stamped, that you've written, hey, in August of 2018, I decided to do this, and this is what I hope it's going to produce. And this is the ways, at least at present, I'm thinking it could go wrong, and here's how it might go right. And then you review that periodically. Very few of us do that, but it's a very healthy thing to do. What gets measured and tracked gets improved.

So if you want to improve your skill as a decision maker, then start tracking the way that you make decisions. Start writing down your reasoning, your thought process, write down pros and cons. Keep a journal of the way in which you make decisions. And then when you have the benefit of hindsight, look back on your thinking process. And remember, don't judge the decision based on its outcome or result. Judge it based on the soundness of the process itself. Thank you for tuning in. coming up on a future episode of the Afford Anything podcast, we have productivity expert Mike Vardy.

He's going to join us to talk about actionable tactics on how you can be more productive and more efficient and more effective. After all, there is that difference between efficiency and effectiveness. So he's going to share specific tactical actionable steps on how you can improve your processes and have more time in your life to do the things that matter. So that is coming up on a future episode of the Afford Anything podcast to make sure that you don't miss it. Please go into whatever podcast playing app you're using, whether it's Google Podcasts or Apple or Spotify, and hit the subscribe button. That way you won't miss any of our upcoming episodes. There's one last thing I'd like to say before we close out this episode. So my friend said this the other day and I thought it was beautifully worded.

He said, those who think money cannot buy happiness have never. experience the joy of giving it away. Wow. Like, I'm going to repeat that, right? Think about this. Those who think money cannot buy happiness have never experienced the joy of giving it away. Now, many of you listening, many people in this community, you do know that joy. Because as of the day that I'm recording this, we, the Afford Anything community, we've raised $3,758 to bring safe clean drinking water to communities around the world that need it. See, here's the thing. Drinking dirty water spreads disease, and diseases from unsafe dirty drinking water

kill more than 800,000 people a year. So think about that. Almost a million people a year die because their water is dirty, and half these deaths are kids under five. So the good news is that this little podcast, this thing that I'm recording from my closet with a pile of dirty laundry next to me, this podcast has created a community, and that community, which is you, have raised $3,758 to save lives.

So the money that we have raised so far is enough to bring clean drinking water to 125 people. And that could save somebody's life. But we're not done yet. So if you'd like to support this cause in the name of the Afford Anything community, here are two ways that you can do it. Number one, go to affordanything.com slash store and buy a shirt. We have three different styles of shirts, and we will be giving 100% of the proceeds from the sale of these shirts directly to Charity Water. So, again, that's Afford Anything.com slash store.

You can pick up a shirt and 100% of the profits go to Charity Water. That is $5.38 per shirt in case you're wondering. That's one option. The second option, if you want to bypass that and make a direct donation, go to Affordanithing.com slash water. you can make a tax deductible donation through the Afford Anything community fundraising page. So again, that is afford anything.com slash water. Thank you so much to everybody who participated in this. Thank you so much to everybody who has been part of that 3758 that we have raised so far.

I'm so proud of this community for all of the support that you've shown. And let's save some lives. Let's make this a thing. Thank you so much for tuning in. My name is Paula Pant. This is the Afford Anything podcast. I appreciate you for joining us. If you like this show, please share it with a friend.

And I will catch you next week.